If you had any medical costs for treatment of emotional distress and did not previously deduct them then these could be subtracted from the settlement to determine the taxable portion of the settlement. In this situation only the amount in excess of the medical costs is taxable.
If you or your spouse (if you are married) have retirement plans (such as a 401(k) or 403(b)) through your employers then you could increase your elective deferral contribution amounts to the plans for the remaining portion of the year to reduce the taxable amounts on your W-2s. Depending on the amount of your gross income including the settlement amount and whether you are covered by retirement plans through your employer(s) you may be eligible to make deductible IRA contributions.
If you itemize deductions, you could try to accelerate some of those to this year such as prepaying some of next years real estate taxes this year, doubling up on charitable contributions this year, or paying off outstanding medical expenses (other than for the emotional distress).
Are the legal fees also deductible? They amounted to over 50% of the settlement. The attorney advised me that the 1099 will be for the full amount, but I will also receive a spreadsheet of the legal costs.
Is there a limit to the amount of charitable donations, in-kind donations, etc I can use this year?
Can I still deduct student loan interest that I pay this year for my children and myself?
The legal fees are deductible as a miscellaneous deduction subject to 2% of your adjusted gross income (AGI) on Schedule A. So the only portion deductible would be the portion in excess of 2% of your AGI. Any other eligible miscellaneous expenses can also be included to meet the 2% level.
Your cash or in-kind (other than capital gain property) charitable contributions are generally limited to 50% of your AGI. Any amounts in excess of this can be carried over and deducted for 5 years.
Whether any of the student loan interest is deductible depends on the level of your income. For 2008, the amount of the student loan interest deduction is phased out (gradually reduced) if your filing status is married filing jointly and your modified adjusted gross income (MAGI) (which will include the settlement) is between $115,000 and $145,000. You cannot take the deduction if your MAGI is $145,000 or more.
For all other filing statuses, your student loan interest deduction is phased out if MAGI is between $55,000 and $70,000. You cannot take a deduction if your MAGI is $70,000 or more.
See page 10 - http://www.irs.gov/pub/irs-pdf/p529.pdf